Let’s say you’re reviewing a financial statement that discloses an area as a critical audit matter, signally that some complex or subjective judgments were made by the auditor. Would that make the statement more useful to you, or would you raise an eyebrow and worry?
If you say the statement is more useful, that’s what the Public Company Accounting Oversight Board wants to accomplish with its recent recommendation to require that auditors disclose critical audit matters in the auditor’s report.
But a new study by researchers at the University of Texas McCombs School of Business, The Disclaimer Effect of Disclosing Critical Audit Matters in the Auditor’s Report, instead reveals a catch-22: Financial statement users would be less confident in an area revealed as a critical audit matter, but the disclosure offers legal protection to auditors if a misstatement is found there.
Accounting professor Steven Kachelmeier, associate accounting professor Jaime Schmidt, and accounting doctoral student Kristen Valentine used attorneys who handle class-action lawsuits for securities fraud cases, attorneys for the defense in such cases, financial analysts, and MBA students in their study because “the perceptions of relatively experienced participants are relevant to a legal environment in which actions against auditors are often settled rather than tried before a jury,” the study states.
Participants were given two scenarios: one in which a disclosure of an area of critical audit matter is required and one without any required disclosure.
Here’s what they found.
Confidence in the financial statement before any knowledge of a misstatement.
- All four groups of study participants indicated significantly lower confidence in an area designated a critical audit matter compared to a different, known risk area not disclosed as a critical audit matter.
- Defense attorneys and MBA students showed significantly lower confidence in an area disclosed as a critical audit matter compared to the other scenario in which the auditor omits any disclosure.
- The disclosures of critical audit matters don’t lower user confidence in general. That suggests that the effect of the disclosures on confidence is specific to the area targeted as a critical audit matter, the study states.
Auditor responsibility for subsequently revealed misstatements.
- MBA students and financial analysts found less auditor responsibility when the misstatement and critical audit matter are in the same area rather than when they are in different areas. “For these groups, the key to lower assessed responsibility is for auditors to identify the ‘right’ critical audit matter,” the study states. These groups were less concerned about the lack of any disclosure because they assessed auditor responsibility about the same whether there is a critical audit matter disclosure or not.
- These groups support the concern expressed by audit firms that a misstatement in a non-critical audit matter area could lead financial statement users to second-guess that the cause of the loss should have been identified as a critical audit matter, the study states. And if that’s the case, then requiring disclosures of critical audit matters could prompt auditors to overdisclose to avoid litigation.
- Defense attorneys assessed auditor responsibility about the same whether the disclosure of a critical audit matter was in the area of a misstatement or not. “Apparently, attorneys who could plausibly take a defense perspective credit the auditor for disclosing any critical audit matter,” the study states.
- Class-action attorneys, on the other hand, showed a high level of auditor responsibility for a misstatement regardless of whether there was a disclosed critical audit matter in the misstatement area, a different critical audit matter, or no disclosures. “In short, class-action attorneys appear to believe that auditors must bear responsibility for material misstatements in financial reports, period,” the study states.
- Still, in post-experiment questions, class-action attorneys said auditors would face less legal exposure for a misstatement if they disclosed the area as a critical audit matter than if they had omitted any disclosure.
“On balance, we conclude that the preponderance of our study’s evidence supports a ‘disclaimer effect’ of critical audit matter disclosures that lowers user confidence in the area but also lowers the auditor’s exposure if a misstatement is discovered in that area,” the study states.
So, how does this play out in the real world? That’s a mixed bag, the researchers acknowledge. Auditors’ clients won’t welcome “asterisks” in statements, as they put it. Then again, if auditors spotlight critical audit matters related to subsequent problems, they may benefit if critical audit matter disclosures partially protect them legally “much as product warning labels can partially protect manufacturers,” the study states.